Capitalism With A Vengeance

By EDMUND L. ANDREWS

Published: October 5, 1997

MOSCOW—
BILL BROWDER started buying Russian stocks before there was a stock market here. It was 1993, the year President Boris N. Yeltsin defeated Communist hard-liners by shelling the Parliament. Industrial output was collapsing; inflation was rampant.

Investing? Russians with money were smuggling billions of dollars out of the country. There were no exchanges, no prospectuses, no earnings reports and almost no earnings.

But there was stock. Under Mr. Yeltsin's privatization program, shares in thousands of former Government enterprises were auctioned off or given to workers and managers. Most people thought these shares were worthless; Mr. Browder thought they were cheap. As Salomon Brothers' 29-year-old manager for Russian equities, and then later on his own, he went to places like Siberia and Tatarstan to snap up shares in oil companies, mines and utilities.

Today, that looks smart. Wearing dollar-sign cuff links and working a few blocks from the Bolshoi Theater, Mr. Browder, now 33, runs what could be the most successful investment fund in the world this year. Shares in the Hermitage Fund, which began in April 1996 with $25 million from Republic National Bank in New York, doubled in 1996 and have nearly tripled again since January. With new money pouring in from wealthy investors and institutions around the world, Mr. Browder now manages $1.2 billion in Russian stocks.

Russia is hot. Six years after the collapse of the Soviet Union, the land of Lenin and Stalin is suddenly gripped by stock-buying fever. Its nascent stock market has shot higher lately than any other, tripling in the last 18 months. Professional traders now swap shares over an electronic trading system. Foreign investment funds like Hermitage, often registered in tax havens like the Cayman Islands, Cyprus and Guernsey, where Hermitage is based, have channeled about $3 billion into Russian stocks. Moscow's top hotels are swarming with Western bankers, brokers and deal makers.

''Almost every major emerging-market stock fund is here,'' said Dirk Damrau, head of research at Renaissance Capital Group, one of Moscow's biggest investment firms. ''Anyone who was in Latin America or Asia or Central Europe is now here.''

The boom has been driven by two things: a conviction that Mr. Yeltsin's economic changes are making Russia safe for capitalism and, more opportunistically, the lure of incredibly cheap assets -- the upshot of privatization plans that bore little resemblance to capitalism as practiced in the West.

Russian companies control some of the world's biggest oil reserves, its biggest supplier of natural gas, its biggest nickel and platinum mines and thousands of huge if decrepit factories. Yet even today, the combined stock value of Russia's 50 biggest companies is less than $150 billion -- about the same as Exxon or Coca-Cola.

The big debate now is whether Russia is still cheap, after the tremendous run-up in stock prices. Most investors agree that the easy money has already been made. But they disagree deeply on whether the market is poised for yet more growth.

By any measure, investing in Russia is a mind-bending experience. Russian companies are in a shocking state of disrepair, needing either billions of dollars in reconstruction or outright demolition. Many managers have brazenly looted assets or ceded control to organized crime bosses. Others have manipulated profits through new holding companies, circumventing original shareholders. Only a few companies report audited financial results; many report almost nothing at all. And many stocks trade so rarely that it can take weeks to buy or sell them.

But the markets here are not filled with penny stocks and Ponzi schemes, though there have been some extremely dubious enterprises. And like most former Communist countries, Russia has had its share of blatant fraud and pyramid schemes.

Many Russian companies, though, are very real -- and very huge. The money pouring into Russian stocks has come overwhelmingly from foreign investment funds whose investors are from Wall Street, London, Hong Kong and elsewhere. While Russia remains too wild for most mutual funds or institutional investors like insurance companies, its sheer immensity has made it impossible to ignore.

Still, the stock boom here is curiously disconnected from the real economy. Most of the trading is between offshore hedge funds. Very little money has actually flowed into the companies themselves because only a handful have raised capital by selling new shares.

And Russia's economy is still a mess. Growth is essentially zero; industrial output has only begun to stabilize after five years of decline. Outside the glitter of Moscow, this remains a land of bleak poverty.

So how surreal is investing in Russia? Consider Unified Energy System, the country's main electric utility and its most-active stock. Its shares have soared nearly 600 percent this year, from 7 cents to 40 cents, after the company reported a modest profit last year on revenues of about $1.7 billion. But those revenues include several hundred million dollars in unpaid customer bills -- and investors don't yet know exactly how many millions or whether U.E.S. will be able to collect much of the money.

Or consider Avto Vaz, which makes 70 percent of all cars in Russia. Despite tough import restrictions that protect it from competition, the company lost $442 million last year and owes $500 million in back taxes. Its cars roll out of the factory with an average of 42 defects apiece and are widely loathed by Russian consumers. But the stock has climbed tenfold, from $1.60 to $16 in the last year, because no one believes the Government will shut down the company.

Some of Russia's biggest oil companies, meanwhile, have systematically shifted their profits into new holding companies -- and out of the reach of most ordinary shareholders. Indeed, many of the most successful investors in Russian stocks have been those who found ways to bet on the side of managers who were draining profits from other shareholders.

''What's important to know is who really owns the stock and whether they are on your side,'' said an American money manager here, who spoke on condition of anonymity. ''If you're fighting against the side of management, you're probably going to lose.''

The Traders

Modern Trappings, Obsolete Methods

At first glance, the trading room at Troika Dialog, the biggest brokerage firm in Moscow, looks like a carbon copy of trading operations in London or New York. But appearances are deceiving.

Several dozen clean-cut men in oxford shirts and conservative ties sit at banks of computer screens, periodically calling out orders on the telephone. The screens flash lists of buyers and sellers for about 200 stocks: Lukoil, Aeroflot, Rostelecom, Moscow Telephone and others. Trades are entered and logged at the touch of a button.

The banter ebbs and flows between English and Russian, but the topics would be familiar in any trading room: bid-ask spreads, sports, difficult clients, night life and who is suddenly buying up 10,000 shares of XYZ stock. During lulls, the traders wolf down hot lunches from foam containers; some practice golf putts in the aisles.

None of this existed two years ago. Aslan Khalichkhov, at 29 a veteran of the Moscow market, still has trouble believing the pace of transformation. When he started in 1994, ''trading'' began when an armored truck would pull up to the cavernous Russian exchange building and unload several million dollars in cash.

''The truck would come at 3 P.M. every day,'' Mr. Khalichkhov recalled. Inside, brokers set up at long tables and waited for people to bring in bundles of the vouchers that entitled holders to shares in newly privatized companies.

''It really was 'over-the-counter,' '' he said. ''At the end of the day, you would change the voucher for money. Then the truck would show at 6 or 6:30, and we would hand over the vouchers.''

Today, about 100 million shares trade daily over the Russian Trading System. Like the Nasdaq system, which electronically links brokers and dealers in the United States, the R.T.S. allows brokerage firms to post competing prices for stocks and execute orders electronically. It is modern, fast and so far free of scandals.

But the old Russia endures just below the surface. Except for about two dozen major stocks, most companies trade so thinly that fund managers often wait days or weeks to complete a big transaction. Reflecting the risk of holding thinly traded stocks, the gap between the prices at which brokers are willing to buy and sell a particular stock can be huge. On one recent day, the highest bid for Novosibirsk Tin Plant was $69, while the lowest selling price was $90.

Indeed, fund managers say most Russian stocks are not exchanged over the R.T.S. system at all; instead, they are bought or sold in private phone calls between clients. To find a hard-to-get stock, fund managers usually hire brokers to scour the town where a company is based.

Even if traders do buy and sell shares electronically, it usually takes at least a week before the shares actually change hands. That is because brokers must re-register the shares, a cumbersome process that often means sending documents back and forth between local registrars who may be thousands of miles apart. If glitches occur, and they do, weeks can pass before the trades are officially complete. By contrast, trades on Nasdaq are settled in three days.

The lag time worries many traders because it increases the risk that a big investor will back out of a trade and prompt a chain reaction of defaults by other traders caught in a sudden squeeze. No calamities have yet occurred, though traders say small-scale defaults are frequent. ''It's a ticking time bomb,'' said Fred Berliner, a burly and bearded former hedge-fund manager from New York who runs Troika's trading room.

The Pioneers

Potential Windfalls, Financial Quicksand

Bill Browder's first epiphany about Russia came four years ago, during a visit to a fleet of fishing trawlers off Murmansk. It was the math that amazed him.

A soft-spoken M.B.A. from Stanford University who had worked for Salomon in Central Europe, Mr. Browder was advising managers who wanted to take a controlling stake in the Government-owned fleet, which was becoming a private company.

The company had 100 ships, each less than 10 years old, which cost as much as $20 million apiece when new. Yet under Government formulas, the managers were able to buy 51 percent of the company for $2.5 million. Put another way, the ships were being sold for a fraction of their real value.

''I came here, saw what was going on and said, 'This is incredible,' '' Mr. Browder recalled recently.

In the helter-skelter rush to privatize some 13,000 companies, shares representing a third of Russia's industrial infrastructure were being valued at about $3 billion just four years ago. Newly private oil companies had stock market valuations that translated into pennies per barrel of oil reserves.

When Russia had a bank panic in 1995, Mr. Browder noticed that Russia's one real bank, which had 70 percent of all deposits and thousands of branches, was relatively solid. Its stock value translated to about $5,000 per branch -- bricks and mortar included -- and has since soared as the dust has settled.

Opportunity? ''This was not rocket science,'' Mr. Browder remarked.

But this was Russia, and nothing was simple. Many Russian companies viewed shareholders with indifference or hostility, and some still do. Many managers had never asked to have their stocks trade publicly, and they had their own ideas about how to manage company profits. But suddenly their stock was ''public'' because workers had sold their free shares for a quick gain.

The lack of attention to ''shareholder value'' was especially glaring at several of Russia's biggest oil companies, where, under one approach to privatization, workers had been given preferred stock equal to about 25 percent ownership. The preferred shares had no voting power but an automatic claim to 10 percent of the company's profits as a dividend. Initially, they sold at a huge discount to ordinary common stock, but as awareness of their dividend potential spread last year, they soared in value by about 1,400 percent.

But that was not the end of the story. Many of the exploration and drilling companies had also been herded together by the Government under new holding companies. By 1996, profits in the original companies started to evaporate, and their share prices languished. The profits, meanwhile, showed up in the new holding companies, some of whose shares have soared more than 1,300 percent this year.

Others might have sued or screamed. Mr. Browder, detecting the profit shift early, decided instead to start unloading much of his preferred stock and start buying shares in the holding companies. These stocks could be acquired from managers at subsidiaries who had swapped their original stock for that of parent companies.

Not surprisingly, shareholder grievances here have become increasingly heated.

In one of the biggest brawls, a group comprised largely of American investors has battled managers at a big Russian steel company, Novolipetsk Metal Works. The Americans investors, led by an offshore fund called Cambridge Capital Management, own slightly more than half the stock but have not been able to get a seat on the board, despite winning eight court decisions. Meanwhile, the company has reported that profits plunged $493 million in 1996.

Last month, dissident shareholders led by Western investors put pressure on a subsidiary of Yukos Oil to drop a stock offering they feared would dilute their shares.

But before they could celebrate, company executives surprised them by announcing yet another reorganization that opened new possibilities for diverting profits.

Mr. Browder, who owns shares in the Yukos holding company, is not concerned. ''When a company does terrible things to the subsidiary,'' he said, ''I would rather be on the side with the power.''

Most Russians are still struggling just to pay their household bills. And pension funds, insurance companies and other institutional investors are just starting here; all together, domestic Russian investment funds manage only about $24 million, according to Skate Investor Services, a Moscow stock research company.

Instead, most of the money pouring into stocks here has come from offshore investment funds like Hermitage. Such funds now manage about $3 billion, most of that from wealthy and adventurous foreign investors. And even that sum is just a tiny fraction of the money that goes into, say, Southeast Asia.

''Right now, it's still for buccaneers,'' said Viktor B. Sakharov, president of the fledgling Moscow Stock Exchange.

The Russian market could edge closer toward becoming a target for more conventional investors over the next two months, however.

Both Morgan Stanley, Dean Witter, Discover & Company and the International Financial Corporation, an arm of the World Bank, plan to include the stocks of Russian companies in their indexes of global emerging stock markets.

A presence on those rosters could draw considerable money from institutional investors, many of whom try to line up their global stock portfolios with the weightings of such indexes.

A big subject of debate is whether Russians who secretly shipped some $50 billion out of the country since 1992 have now begun bringing it back -- perhaps through the offshore funds.

The question is impossible to resolve with certainty, but most money managers say the answer is no.

''Foreign investment will be the key to the recovery,'' said Mr. Damrau of Renaissance Capital. ''The flight capital will probably come back only after the more conservative foreign investors have come back.''

What will draw them here to stay?

Analysts say that the Russian economy will need to show steady growth after five years of nightmarish depression.

Russian companies must begin generating real growth and profits, too, rather than relying on ridiculously valued assets to lure investors.

And money managers must gain more confidence that Russia's commitment to markets is for real.

''Russia is rapidly becoming a much more normal place,'' said Mark Cooke, chief investment officer at Brunswick Capital Management, an investment company in Moscow.

But, he added, ''This is not going to turn into a conventional, cozy little democracy overnight.''

Photos: The Russian Market remains something of a free-for-all. ''Right now, it's still for buccaneers,'' says the president of the Moscow Stock Exchange, above. (Georges De Keerle/Sygma); Bill Browder's background in Russian equities at Salomon helped him get in on the ground floor. He now runs his own fund, with $1.2 billion of Russian stocks. (James Hill for The New York Times)(pg. 1); Delays in settling Russian stock trades are a concern for Fred Berliner, above, a former New York hedge-fund manager, who now runs the biggest trading room in Moscow. (James Hill for The New York Times); Workers were offered shares in companies after the fall of Communism, but most, like these Muscovites in October 1994, quickly sold, leaving stocks in relatively few hands. (Peter Blakely/Saba)(pg. 10) Charts: ''Bear Traps in the Russian Stock Market'' Factors that make investing in Russia wilder than in the United States: AUDITS Most companies still do not produce audited financial results; hardly any produce audits that conform with American Generally Accepted Accounting Principles or International Accounting Standards. PROFITS Profits can be shifted among companies through transfer pricing arrangements: An oil production company might sell its oil at low cost to a separate holding company for resale at much higher profit. SHAREHOLDER REPRESENTATION Though Russian laws theoretically guarantee shareholders proportional representation on boards of directors, some companies blatantly refuse to comply. Example: Novolipetsk Metal Works, which has blocked Western investors who control over 50 percent of its stock from getting any seats on its board. FOR RUSSIANS ONLY Some stocks can be bought only by Russian investors, including much of the stock of Gazprom, the world's biggest natural-gas distributor. Gazprom American depository receipts are twice as expensive as identical shares in Russia. HIDDEN TRADING More than 200 companies have stocks quoted on the Russian Trading System, but as much as 80 percent of trading is not formally reported. Brokerage firms do not have to report trades between themselves and their clients, and most such trades go unreported. Indicators of stock activity are not necessarily accurate. TRADING Not over 'til it's over. Actual settlement of trades over the Russian Trading System can take five days or longer, because shares must be reregistered in a cumbersome process. If a trade is not settled within a week, an investor can legally back out. ''Follow the Money'' Analysts say one of the hazards of investing in Russian stocks is the ease with which profits can be shifted among the business units of Russia's complex business groups. An example is Sidanko Group, the country's second-biggest oil company. Its publicly traded subsidiaries all reported losses or earnings declines for the first half of 1997, while the parent company's earnings were tripling. Holders of certain subsidaries' shares received returns far below the Moscow market's average. (Sources: Bloomberg Financial Markets (stock performance); Brunswick Brokerage; Creditanstalt) ''Russia's Bargain Basement'' The big driver of the stock market has been the chase of cheap assets. Here are some current examples that suggest Russia may still be a bargain. PETROLEUM Oil for 75 cents a barrel. That is the average stock market capitalization for Russia's giant oil companies, calculated against their oil reserves, versus more than $11 for American companies. UTILITIES Power plants at one-fifth the market rate. Russian electric utility stocks price them at $201,000 for each megawatt of generating capacity, versus about $1 million for each megawatt to build a new plant. COMMUNICATIONS Moscow City Telephone's stock value is $870 for each access line, compared with anywhere from $1,000 a line in the United States to $3,000 a line in fast-growing developing markets like Brazil. (Sources: Brunswick Securities, Moscow; Hermitage Capital Management)(pg. 10) Graph: ''Is It a Bubble?'' While Russia's economy has been growing slowly, if at all, the Moscow stock market has soared since the spring of 1996. Graph plots the Moscow Times index since January 1995. (Source: Russian European Centre for Economic Policy)(pg. 11) Illustrations by Randy Jones (pg. 10)